Guest post: Reflections on Fama (By Otto Brøns-Petersen)

If I ever had a real mentor I would have to say it was Otto Brøns-Petersen. Otto was my boss when I started working at the Danish Ministry of Economic Affairs in the Mid-1990s. Otto taught me a lot about economics, but he particularly taught me to understand the politics of economic policy making. Something that made me tremendously skeptical about the ability of policy makers to do the “right thing”.

While I left government work long-time ago Otto kept working for the Danish government until recently. However, he is now Head of Research at the Danish free market think tank CEPOS.

Recently Otto wrote a piece for the Danish business Daily Børsen on some policy implications to draw from Nobel Prize winner Eugene Fama’s work. I asked Otto whether he would be interested in writing a similar piece for my blog . I am happy he accepted the challenge.

- Lars Christensen

PS After knowing Otto for nearly 25 years I just realized I would describe his economic thinking as Coasian more than anything else.

Reflections on Fama

- By Otto Brøns-Petersen

This year marks the 50th anniversary of Eugene Fama’s demonstration of “random walk” in stock prices. The price today does not predict the price tomorrow. Rather, stock prices absorb the information available to the market at any given time. As financial markets do not systematically omit information, there are no systematic price movements. The market is “efficient”.

In the longer term, however, patterns in price movements do emerge. Fama has been leading the research into how such patterns can be explained and what they mean. A couple of weeks ago, he and two other American economists, Lars Peter Hansen and Robert Shiller, were awarded the Nobel Prize in Economics for their empirical work on pricing in financial markets.

Does this mean that we have now cracked the code of what drives prices in the long term? Far from it! Fama’s research continues, and his colleague, John Cochrane, even believes that he has his best work ahead of him. Futhermore, with its choice of laureates, the Nobel Committee choose to highlight that there are two very different and competing approaches to understanding financial markets. Fama’s approach is to look for rational investor motives. In particular, it appears that changes in investors’ risk aversion can explain movements in prices over time. Shiller’s approach, on the other hand, is based on behavioral economics, which looks for psychological motives that are not necessarily rational.

Can we learn something from this research, something about good policy? In my opinion, we can indeed.

Firstly, bubbles in the financial markets are very difficult to predict. Disagreement about how empirical price movements should be interpreted theoretically is in itself an element of unpredictability. But although consensus on the interpretation of historical data might increase, predictability about the future will not necessarily do so too. Researchers are watchingers are not alone in looking over their shoulders for/at investors, but investors are also watching also looking over their shoulders for/at scientists and their research.. There is money to be made from learning how to avoid historical errors in the future. In particular, theories of systematic errors will tend to undercut themselves because of learning by agents. So, we should not expect to be able to predict bubbles.

Secondly, cognitive and psychological limitations on rationality not only apply to investors but also to politicians and officials. If investors have exaggerated beliefs about being able to get out of a market before it falls, one should be concerned about a similarly exaggerated belief of authorities that they can trace an unsustainable market development before it is too late.

Thirdly, it is crucial to realize whether incentives support appropriate behavior in financial markets. Basically, there are very strong incentives to avoid errors for investors who have their fortunes at stake. And the financial markets even support rational behavior by selecting good investors at the expense of bad ones. Markets, so to speak, entail what we could call “systemic rationality”. If incentives, on the other hand, reward inappropriate behavior – eg. in the form of moral hazard, where the bill for mistakes ends up with someone else than the decision-makers – one should indeed expect more inappropriate behavior. Finally, it is important to be clear about the incentives not just for agents in the financial markets, but also for political and bureaucrat decision-makers.

In my opinion, there is reason to worry whether policy makers are drawing the wrong lessons from the financial crisis in their policy response. Financial Supervisory Authorities, central banks and central government officials have been asked to step up surveillance of the macro economy, financial markets and financial institutions. Regulation is on the rise. Actual improvements in incentives are, however, still missing.

One might ask: Doesn’t increased monitoring just add extra security and isn’t it in the worst case harmless? Unfortunately, it also has costs.

Firstly, it may give the agents in financial markets and customers in financial firms a false sense of security, giving authorities greater moral responsibility for financial crises and thus increase the likelihood of government bailouts. Thus, it increases the moral hazard problem and distorts incentives.

Secondly, the increased monitoring to avoid one type of error increases the frequency of another type of error. We may (but not very likely) discover more bubbles early on, but at the expense of more false alarms and misguided political interventions. At the same time, the incentive structure of authorities seems unsound. It will attract attention if a crisis is overlooked, whereas it is harder to tell if an intervention was based on a wrong diagnosis. There is thus a built-in propensity for political action, and the ever-changing political winds add a further element of instability in regulation and legislation.

Interestingly enough, the recent Danish Government Committee on the Financial Crisis noted that liberalization of financial markets has been a net economic advantage, both advantages and disadvantages taken into account. There is a need for a similar assessment of financial regulation and supervision in general.

It is perhaps understandable that many after the financial crisis instinctively conclude that “someone ought to watch out and make sure we will not see another crisis.” But it may well be a little like hoping for someone to come up with a “sure thing” stock advice. Neither is founded in reality. The effective tools in the toolbox of economists are called: Incentives, incentives and incentives.

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Guest post: Central bankers should watch the Eurovision (by Jens Pedersen)

Guest post: Central bankers should watch the Eurovision

By Jens Pedersen

Congratulations Emmelie de Forest with the 2013 Eurovision song contest first place. You have made all of Denmark very proud!! Denmark normally does not win anything, so this is really big for us! (note the irony…)

However, I regret to say that I did not watch the competition yesterday. Not that I do not like a good song contest or that I am not a patriot rooting for my country.  The reason that I did not watch the song contest was simply that the bookmakers had Denmark as a heavy favourite to win and history shows that the bookmakers are rarely wrong in their Eurovision predictions. Bookmakers have correctly predicted four out of last five Eurovision winners. Hence, the results were pretty much given before hand, which really takes away all of the excitement.

I do, however, hope that every central banker out there watched the Eurovision song contest yesterday. It serves a great example that looking at market expectations is the best way of predicting the outcome of an uncertain event.  If markets can predict the winner of the Eurovision they should also come pretty close at predicting the future rate of inflation, real and nominal GDP growth, the rate of unemployment etc. Hence, the first thing central banks should do on Monday is to set up prediction markets for key economic variables. This will be a great help in guiding future monetary policy decisions.

Guest post: Cantillon and Central Banking (by Justin Merrill)

Lately there has been somewhat of a debate between some Market Monetarists and some Austrians about the so-called Cantillon effect. I have not participated in the debated – last time I wrote about the Cantillon effect was actually in my Master thesis on Austrian Business Cycle theory in the mid-1990s and to be frank I have not made up my mind entirely on this discussion. Therefore, I am happy Justin Merrill have written a guest post for my blog on the topic.

As it is always the case I do not necessarily agree with what the authors of guest posts on my blog write, but I always hope that guest posts can help further the debate about monetary policy and theory issues. I believe that Justin’s post is doing exactly that.

Please enjoy.

Lars Christensen

Guest post: Cantillon and Central Banking
by Justin Merrill

Much has been written recently on the topic of Cantillon effects. I risk alienating myself by potentially disagreeing with everyone, but I hope I can persuade others to see it my way. At the extremes there are two points of view. The rational expectations view basically asserts that money is neutral when inflation is expected, and therefore the Cantillon effects can largely be ignored. On the other end of the argument is the exploitative theory of state money, whereby the issuer of the currency, the banks, the politically connected, and the government employees and contractors benefit at the expense of everyone else. While both of these have nuggets of truth, they also have flaws that make them inapplicable to our current monetary system.

After a careful rereading of Sheldon Richman’s article, I agree with it almost entirely with the exception of one part:

“Since Fed-created money reaches particular privileged interests before it filters through the economy, early recipients—banks, securities dealers, government contractors—have the benefit of increased purchasing power before prices rise.”

Cross out “government contractors” from the above sentence and it is true. This is because contractors are paid out by the Treasury, which gets the vast majority of its funds from taxation and financing. This confuses fiscal transfers with monetary ones. Since the Treasury does not print money directly a la greenbacks, the government does not receive a 100% seigniorage from central bank operations. A lot of Rothbardians also make the mistake of assuming that all bank credit expansion represents a windfall gain to the issuing bank and the borrower, but this ignores that banks have to pay interest to their depositors and it is not costless to expand.

But are the Market Monetarists right that there are not Cantillon effects from open market operations since primary dealers are selling bonds to buy reserves? Not quite. The primary dealers do benefit by getting the privilege of selling securities at a premium to the market rate and buying at a discount. The gain might be small, but it exists; otherwise PDs would not have an incentive to participate in OMOs. This is effectively a risk free arbitrage that doesn’t arise out of entrepreneurial awareness, but political connectedness and size. Libertarians may overstate the size of this privilege, but it shouldn’t be ignored. Interest paid on reserves to banks and Federal Reserve profits turned over to the US Treasury are also direct injections of new money. The total amount is roughly $100 bil a year (Fed’s reported profits plus its deposit liabilities times .25%), not including the unknown arbitrage gains that PDs make from trading.

Imagine that we are on a gold standard and the price of gold is $1,000/oz. A gold miner may have a cost of production of $990/oz. He therefore earns $10 of purchasing power by adding to the outside money supply.

Now imagine that in our current system a PD buys a security for $990 and sells it to the Fed for $1,000, he also earns $10 of purchasing power.

In both cases of base money expansion, there are Cantillon effects, but the second one is largely due to legal privilege. Once the outside money enters the banking system, there are secondary Cantillon effects. Banks’ cost of capital is lowered, increasing their profit margins. They may increase their investments, benefiting prior holders of said investments, or they may increase their lending, putting new money in the hands of the borrower and shortly into the hands of the person selling the financed asset.

The way that monetary policy transmits can be difficult to predict through the credit channels. Different firms have varying access to capital markets. Small businesses rely on bank and trade credit, while large firms may be able to issue commercial paper at extremely low rates. In a credit crunch, small firms will be cut off from credit even if the Fed is aggressive with monetary policy. The beneficiaries, relatively speaking, will be primary dealers and issuers of commercial paper that can borrow near zero and lend through trade credit at high rates of interest.

This is one reason I am skeptical of NGDP targeting. I do not think output and asset prices can be kept in equilibrium through central banking. Even though I prefer NGDP targeting to inflation targeting, I think stable NGDP is a probable outcome of monetary equilibrium, not an end in itself. The transmission mechanism between reserve creation and output and inflation is messy and unpredictable.

In summary:

1) Don’t confuse fiscal and monetary transfers.

2) Austrians may sometimes be inarticulate at explaining Cantillon effects in our current system (a person counterfeiting money in his basement is not the same as OMOs) but it still exists.

3) Cantillon effects will exist in any system, but their magnitude and consequences are dependent on the institutions.

4) Money is not injected in a “helicopter drop” and should not be assumed neutral through rational expectations.

5) Non-neutral money can create malinvestment through the banking system and credit channels and it matters what the central bank buys and its impact on the yield curve.

References:

Inside the Black Box: The Credit Channel of Monetary Policy Transmission by Bernanke and Gertler

Guest post: Market Monetarism and Financial Crisis (by Vaidas Urba)

Guest post: Market Monetarism and Financial Crisis
by Vaidas Urba

Market monetarists agree that stable NGDP path is the policy goal. They usually go on to argue that monetary policy should have a single target: market expectations of NGDP, and a single instrument: the size of the monetary base. Often the EMH is considered to be true, and accordingly, it is not important what assets do central banks hold. Sometimes it is even argued that the central bank is not a bank.

Contrast this to the approach found in Woodford’s May 2009 presentation to the Bank of England, where there is an additional instrument of credit easing that is used to address large financial disruptions. In this post I will try to give this second instrument a distinctly market monetarist flavor.

Economic agents are concerned with the monetary environment in two ways – they want to know the forecast of NGDP, and they want to know the forecast of NGDP volatility. The best way to forecast the NGDP would be to use NGDP futures market data, and the best way to forecast the volatility of NGDP would be to look at NGDP options market (unfortunately these markets do not exist yet). While central banks are in a full control of NGDP expectations, according to the traditional market monetarist perspective they can do nothing to influence the expected volatility of NGDP (apart from implementing NGDPLT regime itself).

If we introduce financial market frictions, and examine what happens when markets are not very efficient, we will notice that by selling and purchasing NGDP options, central banks can move the market price of NGDP options, thus changing the ex-ante market estimate of NGDP volatility. When central banks reduce the price of NGDP options, they decrease the probability of a financial crisis, risky portfolios become more attractive, and ex-post volatility of NGDP is reduced. During normal times, central banks have little power to influence NGDP option markets (although a case could be made for a countercyclical NGDP option intervention in order to lean against asset market bubbles while keeping NGDP futures peg unchanged). During financial panics, when market efficiency takes a big hit, the power to change the market estimates of NGDP volatility becomes more significant, and by selling NGDP volatility insurance to the market, central banks can perform the lender of the last resort function in a transparent and non-discriminatory manner while avoiding bailouts and subsidies.

So in this version of market monetarism there are two monetary targets – expected NGDP and expected volatility of NGDP, and two instruments – size of the monetary base and interventions in the NGDP option market. The second target and the second instrument are less important than the first, as the ability to influence the NGDP options market is weak. In addition, it is not possible to avoid discretion when setting the NGDP volatility targets and determining the size of NGDP option interventions.

Purchases of risky assets by the central banks can be justified on market monetarist grounds to the extent these assets replicate the NGDP options. There is a clear difference between the asset and liability operations of the central bank – you issue base money to increase expected NGDP, you purchase risky assets to reduce the expected volatility of NGDP. Selgin’s asset purchase proposal and ECB’s LTRO collateral framework operate with a wide range of financial markets, so their effects are likely to be similar to the sale of NGDP insurance. We can see that the equity capital of central banks is important, without the capital cushion, a central bank would not be able to credibly intervene in the NGDP option markets. This is why central bankers are very concerned with the strength of their balance sheet; they know that macroeconomic volatility would be very high if central bank is undercapitalized.

Fiscal cliff

Is the fiscal cliff dangerous? Yes. Sudden changes in fiscal environment increase the value of NGDP options. Even if NGDP expectations do not change due to reaction by monetary authorities, it becomes likelier that NGDP will overshoot or undershoot the target path temporarily, as it is very easy to make mistakes when forecasting an impact of a large fiscal change. So market monetarists should argue for a gradual fiscal consolidation, even when NGDP level targeting regime is in operation. Of course, the fiscal cliff is especially dangerous when monetary policy does not have a level targeting feature.

Great recession

We can use this framework of dual monetary policy targeting to arrive to a better understanding of Fed’s policy during the Great Recession. However, instead of NGDP and its volatility, inflation and its volatility will be used here, as it more closely corresponds to Fed’s thinking. Fed Governor Frederic Mishkin has explained it in March 2008: “Although a distinctly different concept from inflation expectations, policymakers need to be concerned about any widening of inflation uncertainty.  Indeed, an increase in inflation uncertainty would likely complicate decision making by consumers and businesses concerning plans for spending, savings, and investment.”

In 2007 and 2008, in addition to steering the inflation expectations via the fed funds rate, the Fed has started various asset-side programs (TAF, TSLF, CPPF, and others) that increased its risky asset holdings. In effect, the Fed has sold macroeconomic risk insurance, and by doing this, it has reduced the expected volatility of inflation. In April 2008, Bernanke worried that the size of Fed’s balance sheet would not be sufficiently large to accommodate the need for asset purchases, and there were discussions about starting the payment of interest on reserves. By paying interest on reserves, the Fed would be able to expand the asset-side programs without losing the ability to use fed funds rate to target inflation expectations.

The summer of 2008 was a period when the Fed has started to make serious mistakes about inflation expectations. It is remarkable how all the efforts to reduce inflation uncertainty via asset-side programs came to nothing when deflationary mistakes in the course of the regular monetary policy caused a renewed episode of financial instability that culminated with the default of Lehman Brothers.

After Lehman, the Fed continued its mistakes in steering inflation expectations, in addition, it underestimated the size of asset side operations that were needed to control inflation volatility.

Things got so bad that the Fed had temporarily lost the power to set the fed funds rate, as evidenced by the TED spread and the standard deviation of effective fed funds rate.

In October 2008, the loss of the fed funds rate instrument meant that the inflation expectations were crashing as the misreading of the economic situation by FOMC was compounded by interest rates that were higher than FOMC intended. A large dose of additional asset-side purchases was required until the Fed regained the ability to steer its preferred policy target. The ECB was the most successful of main central banks in adapting to the post-Lehman situation, on 8 October 2008 the ECB announced the switch to the full allotment procedure that on 13 October 2008 was extended to the provision of dollar liquidity. The ECB’s promise of unlimited dollar liquidity against a large pool of diverse European assets was one of the most important actions that led to the restoration of Fed’s control over the dollar fed funds rate, it also contributed to the reduction of inflation uncertainty.

Market monetarism is the best way to fix the liability policy of central banks. NGDP level targeting would have prevented the Great Recession. However, the Great Recession shows us how a financial crisis can disrupt the market that the central bank uses as its instrument. If a financial crisis happens when NGDP level targeting regime is in operation, central banks should be ready to use asset side policy to preserve the integrity of NGDP futures markets. Even when NGDP futures peg is in place, macroeconomic environment can be unstable if expected volatility of NGDP is too high.

Guest post: Thoughts on Policy Uncertainty (Alex Salter)

Even though I think the primary economic problem in the US and in Europe at the moment is weak aggregate demand due to overly tight monetary policy I certainly do not deny the fact that both the US and the euro zone face other very significant problems. Among these problems are considerable “regime uncertainty”. In fact I believe that regime uncertainty is the key economic problem in a number of countries such as Venezuela, Argentina and Hungary. I have in earlier posts (see links below) argued that regime uncertainty primarily should be seen as supply side phenomena. However, regime uncertainty can also be seen as a demand side problem.

In today’s guest post the young and talented Alex Salter discusses a framework in which to discuss regime uncertainty or policy uncertainty – both as a supply side and a demand side phenomena. I think Alex’s discussion is highly relevant  and is quite useful in understanding regime uncertain conceptually .

Enjoy Alex’s guest post.

Lars Christensen.

Guest post: Thoughts on Policy Uncertainty

By Alex Salter, George Mason University

There’s been some talk lately about policy uncertainty and its effect on economic activity.  It’s important to pin down just what economic effects we’re talking about here.  In particular, we need to decide whether policy uncertainty (also called ‘regime uncertainty’ by economist Robert Higgs, who was talking about it before it was in vogue) is a demand-side or a supply-side phenomenon.  I’ve seen arguments for both sides.

Here’s my take on it: In the short-run it’s a demand phenomenon.  But it has long-run supply consequences.

Policy uncertainty stems from uncertainty with respect to the future structure of property rights.  If I’m not sure what regulatory policy, tax liability, etc. for various economic activities will look like, then there’s a real option value to holding off on investing in an enterprise (Avinash Dixit has some really interesting papers on this).  This, of course, means lower investment spending than there would be otherwise.  The standard Aggregate Demand-Aggregate Supply (ADAS) framework provides a quick-and-dirty way of looking at this.

First off, let’s work in growth rates instead of levels.  I think it makes the analysis easier.  The AD curve is given by.  This is the dynamic form of the familiar quantity equation,.  The little g denotes growth rates.  Note that the AD curve shows all combinations of inflation and real income growth that map to a constant level of nominal income growth.

AS is, as usual, broken down into short-run and long-run components.  SRAS is a standard Lucas supply curve, which is an increasing function of inflation expectations.  LRAS depends on the real productive capacity of the economy; it is vertical to reflect long-run monetary neutrality.

In the short run, policy uncertainty manifests itself as reduced investment expenditure.  Assuming a constant level of money supply growth, this is essentially a negative velocity shock, and hence a negative AD shock, as shown below:

The economy, initially in long-run equilibrium at point a, moves to point b, below its long-run potential growth rate.

Ordinarily, the reduction in money flows throughout the economy would put downward pressure on prices, leading to disinflation (or outright deflation if the shock is big enough).  The SRAS curve would shift down as the economy adapted to the new expenditure pattern, bringing us back to long-run equilibrium with the same growth rate as point a, but lower equilibrium inflation.

However, this is not the whole story.  Policy uncertainty, by hampering investment spending, has lowered the rate of capital formation relative to what it would have been in the uncertainty-free counterfactual.  The old long-run growth rate, given by the position of the LRAS curve, is no longer sustainable due to this reduced rate of capital accumulation.  The long-run effects of policy uncertainty are reflected in a reduced potential growth rate for the economy, represented by an inward shift of the LRAS curve:

As I have drawn it, the inward LRAS shift meets the transition down AD’ (reflecting larger income growth relative to inflation growth over time, still yielding a constant level of nominal income growth).  The result is long-run equilibrium at point c.  Again, real income growth is permanently lower because regime uncertainty, by hampering capital formation, has reduced the economy’s real productive activity vis-à-vis the no-uncertainty world.

This is obviously an oversimplified (and overaggregated!) model, but I think it captures the short-run/long-run distinction well enough for the purposes of getting our thinking straight.  There are all sorts of bells and whistles you could add to this.  For example, you could look at what happens after the uncertainty plays out (property rights become better-defined, either at a permanently “stronger” or “weaker” level).  The new equilibrium would be different depending on how you model actor expectations (rational, adaptive, etc.)  The grad students out there might want to spice things up by examining this in a Ramsey-style model and playing with the dynamics.

Now that we’ve got our terminology squared away, we can proceed to the really interesting questions—namely, how regime uncertainty plays out at the micro level, with the accompanying distortions in relative prices (and thus resource misallocations).  There are all sorts of political economy implications to work through as well.

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Related posts:

Regime Uncertainty, the Balkans and the weak US recovery
Papers about money, regime uncertainty and efficient religions
”Regime Uncertainty” – a Market Monetarist perspective
Monetary disorder in Central Europe (and some supply side problems)

Guest post: Misunderstanding Say’s Law of Markets (Garrett Watson)

I have always wanted to promote the work of young scholars on this blog and have been grateful that a couple of gifted young economists have published guest posts on this blog. I want to continue that “tradition” and I am therefore happy that Garrett Watson – a student of Steve Horwitz at St. Lawrence University – has accepted my invitation to write a guest post for my blog.

Enjoy Garrett’s excellent discussion about the “Misunderstanding Say’s Law of Markets”. The post has previously been published on Tu Ne Cede Malis.

Understanding Say’s Law and the connection to monetary policy is key to understanding the present crisis. So enjoy Garrett’s guest post.

Lars Christensen

 

Guest post: Misunderstanding Say’s Law of Markets

- By Garrett Watson, St. Lawrence University

Few ideas in the history of economic thought have achieved a level of perplexity and criticism than Say’s Law. Perhaps one of the most misunderstood and elusive concepts of the Classical economics, Say’s Law of Markets, first postulated by John Baptiste Say in 1803, underwent considerable support and eventual decline after its assault by John Maynard Keynes in The General Theory. Many of the fundamental disagreements we observe in historical debates surrounding macroeconomics can be traced to different conceptions of how Say’s Law operates in the market economy and the scope used in the analysis. By grasping a thicker idea of Say’s Law, one is able to pinpoint where disagreements in both macroeconomic theory lie and judge whether they necessarily must be dichotomized.

Say’s Law is best known in the form Keynes postulated it in The General Theory: “supply creates its own demand” (Horwitz 83). Despite the apparent eloquence and simplicity contained in this definition, it obscures the genuine meaning of the concept. For example, one may interpret this maxim as meaning that whenever one supplies a good or service, it must be demanded – this is clearly untrue (83). Instead, Say’s Law can be interpreted as saying that the ability to produce generates their ability to purchase other products (84). One can only fully grasp Say’s Law when analyzing the nature of the division of labor in a market economy. Individuals specialize in producing a limited range of goods or services, and in return receive income that they use to buy goods and services from others. The income one receives from production is their source of demand. In other words, “all purchasers must first be producers, as only production can generate the power to purchase” (84).  This idea is intimately linked to the Smithian idea that the division of labor is limited by the extent of the market (89).

The result of this fascinating principle in the market economy is that (aggregate) supply will equal (aggregate) demand ex ante as demand is equally sourced by previous production (Sowell 40).  Another important point made by Say’s Law is that there exists a trade-off between investment and consumption (40). In contrast to the later Keynesian idea of falling investment leading to a fall in consumption and therefore aggregate demand, an increase in investment means falling consumption, and vice versa. This idea can be analogized to Robinson Crusoe abstaining from consumption to build a fishing net, increasing his investment and his long-term consumption of fish (42). Therefore, a higher savings rate pushes up investment and capital accumulation, increasing growth and output (as Smith eloquently argues) (40). In another stark contrast to Keynesian analysis, there is only a transactions demand for money, not a speculative nor a precautionary demand (40). The implications of this are that money cannot affect real variables; it is a veil that facilitates transactions only – money is neutral (Blaug 148). Finally, Say’s Law also shows that there cannot exist a “general glut”; an economy cannot generally overproduce (Sowell 41). Whilerelative over and under-production can occur, there is no limit to economic growth (41).

While it was uncontroversial among the Classical economists that there wasn’t a limit on economic growth, several economists took issue with the fundamental insights of Say’s Law (44). One of the most well-known criticisms was that of Thomas Malthus. Malthus was an early proponent of the “Paradox of Thrift” – an excessive amount of savings could generate an economy with less than full employment (43). One could describe the view of Malthus as fundamentally “under-consumptionist” (Anderson 7).  Unlike his contemporaries, Malthus did not view money as inherently neutral (Sowell 41). Other classical economists, such as Smith, argue that money “will not be allowed to lie idle”, effectively dismissing a precautionary motive for holding money and therefore monetary disturbances (38). This is where we see the inherent difference in perspective in the analyses of Smith and Malthus. Smith is focused on long-run conditions of money (its neutrality and importance of real fundamentals) versus the short-run disturbances money can generate in output (39).

Money is half of every exchange; a change in money can therefore spill over into the other half of every exchange, real goods and services (Horwitz 92). In effect, “The Say’s Law transformation of production into demand is mediated by money” (92). This means that Say’s Law may not hold in conditions in which monetary disturbances occur. John Stuart Mill recognized this possibility and affirmed Walras’ Law: an excess of money demand translates to an excess supply of goods (Sowell 49). An excess money demand manifests itself by individuals attempting to increase their money balances by abstaining from consumption. This therefore generates an excess supply of goods, which some would argue can be self-correcting, given downward adjustment of prices (Blaug 149). Malthus (and later on, Keynes) argues that downward price and wage rigidities (which can be the result of game theoretic problems in firm competition, efficiency-wages, or fixed wage contracts) can short circuit this process, yielding a systematic disequilibrium below full employment (Sowell 65). In terms of the equation of exchange, instead of a fall in V (and therefore a rise in money demand) being matched by a fall in P, the fall in V generates a fall in Y. This point was taken into further consideration by later monetary equilibrium theorists, including Friedman, Yeager, and Hutt.The same analysis can be used to understand the effects of drastic changes in the money supply on short term output, as Milton Friedman and Anna Schwartz would demonstrate in the contraction of the money supply during the formative years of the Great Depression

When analyzing the large disagreements over Say’s Law, it becomes clear that they stem from a difference in scope: supporters of Say’s Law analyzed the macro economy in terms of long-run stability, while Malthus and others after him focused on short-run disequilibrium generated by monetary disturbances (Sowell 72). Smith and other classical economists, pushing back against mercantilist thought, emphasized that money was merely a ‘veil’ that does not affect economic fundamentals, and that quantities of money ultimately didn’t matter (72). The Malthusian grain of truth regarding disequilibrium caused by monetary disturbances in the short-run does not refute Say’s Law; it reveals the necessity of getting monetary fundamentals correct in order for Say’s Law to cohesively operate. It becomes increasingly clear that once we look at the disagreements through the lens of scope, the two conceptions of the role of money in a market economy need not necessarily be incompatible.

References

Anderson, William. “Say’s Law: Were (Are) the Critics Right?” Mises Institute1 (2001): 1-27. Mises Institute. Web. 19 Oct. 2012.

Blaug, Mark. “Say’s Law and Classical Monetary Theory.” Economic Theory in Retrospect. 4th ed. Cambridge: Cambridge University Press, 1985. 143-160. Print.

Horwitz, Steven. “Say’s Law of Markets: An Austrian Appreciation,” In Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Steven Kates, ed. Northampton, MA: Edward Elgar, 2003. 82-98. Print.

Sowell, Thomas. On Classical Economics. New Haven [Conn.]: Yale University Press, 2006. Print.

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 4, by Clark Johnson)

Guest post: Part 3 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

EQUILIBRIUM WITH UNEMPLOYMENT

Keynes essential claim in the General Theory was that unemployment could persist for years, even if wages and other factor costs were flexible.  The point was that even if factor costs fell, the marginal efficiency of capital might not recover because it was driven by market expectations — which were volatile, and trending downward.  Falling costs might even be taken, not as restorative, but as evidence of weak demand and sagging investment prospects.  Investment might then stay below the level needed to maintain full employment.  Keynes was not claiming that general equilibrium was maintained in the face of unemployment, as critics were later to assert.  He used the term “equilibrium” more modestly to mean that unemployment could persist, and that it was not self-correcting.

Keynes never really explained why he thought monetary policy worked mainly through its effect on interest rates, rather than directly on demand.  This paper suggests the hypothesis that he saw accumulation of physical capital as inexorably leading to lower capital efficiency and declining profits.  With this premise, an attempt to reboot investment by increasing money and prices – even if it succeeded in the short run — would just mean more rapid accumulation of capital, and hence more rapid decline in profits, in a self-reinforcing stagnationist circle.  This conclusion was falsifiable, and has been falsified.  To be fair, it pushes Keynes’ suppositions to the edge of what his text might support, and Keynes never wrote it down, not in so many words.

Keynes was more inclined to dodge the whole topic, either by indirection or deliberately.  The best example of his dodge on monetary factors comes near the beginning of the General Theory, where Keynes quotes John Stuart Mill’s description of Say’s Law, the classical doctrine according to which “supply creates its own demand.”  Keynes sets up Say’s Law as a counterpoint for his own theoretical grand design.  Keynes quoted Mill to demonstrate that “classical” economists thought it possible to “double the purchasing power” merely by “doub[ling] the supply of commodities in every market.”[1]  Astonishingly, Keynes then chopped off the rest of Mill’s paragraph, in which was included –

…money is a commodity; and if all commodities are supposed to be doubled in quantity, we must suppose money to be doubled too, and then prices would no more fall than values would.[2]

Algebraically, an excess supply in one market must be matched by an excess demand in another.  A shortfall of demand for goods implies a matching excess (unsatisfied) demand for money.  Mill and other Classics recognized this – it was not Mill but Keynes who typically neglected discussion of such monetary dynamics.  Mundell highlighted this omission decades ago:

…Keynes perpetrated an historical error in the economics profession lasting several years, a distortion of the classical position that to this day remains in the elementary textbooks.  By thus attacking the logic of the central feature of the classical theory through carelessness or mischievous omission of its essential parts, Keynes was able to win disciples over to the belief that there was a fatal logical defect, an absurd premise, in the classical system.[3]

With somewhat more effect, Keynes did provide a critique of the conventional Quantity Theory   of money – which he had himself endorsed in his earlier Tract on Monetary Reform.  In the Treatise, he argued the case over several chapters that some cost and other factor price increases were tied directly to increases in the quantity of money, while price increases that feed into profits might be less correlated with changes in the money supply.  Indeed, where demand for money increases, a higher quantity of money might even correlate with lower aggregate profits and hence with lower prices.[4] Slaying the Quantity Theory, so to speak, was important to many of Keynes’ early followers, in whose understanding it opened the way to an active role for the State and to deploying an array of fiscal “multipliers.”

It is otherwise less important.  Monetary economics has by now moved past the Quantity Theory, or growth of the money supply, as a policy marker.  Lars Svensson and Scott Sumner recommend that central banks stabilize expectations by targeting a steady rate of growth in Nominal GDP.  Svensson has written that Milton Friedman told him late in his life that monetarists should target nominal GDP rather than growth in the money supply.[5]  I would qualify their recommendation with the suggestion, given the dollar’s role as the world economy’s key liquid asset, that US monetary authorities should also target foreign exchange rates during financial crises, especially the dollar-euro rate.  But nothing about moving beyond the Quantity Theory makes monetary policy less important, or makes interest rates the only channel, or they main channel, through which it can be effective.

The historical illustrations in the opening section suggest that economic slumps and unemployment persisted because effective monetary expansion did not occur.  This was true even where interest rates were already very low and where the marginal efficiency of capital was falling sharply.  The de-stabilizing factor was inept monetary policy, or inability to change such arrangements as the international gold standard.  The irony is that Keynes, the acclaimed revolutionary of Depression economics, had so little to say about the uses of monetary policy when interest rates fell to historic lows and anticipated investment returns went even lower.  Perhaps this was because he sought changes in the relationship between State and Market for which considerations of monetary economics were a distraction.

But faced with the aftermath of the 2008 financial sector crisis and the ongoing Euro-zone crisis, we should avoid such distraction.


[1] General Theory, p. 18.

[2] J. S. Mill, Principles of Political Economy, 1909 edition; p. 558.)

[3] Mundell, Man and Economics, 1968; p. 110

[4] See also, General Theory, pp. 208-209.

[5] Lars E.O. Svensson, What have economists learned about monetary policy over the past 50 years?  January 2008.  At http://www.princeton.edu/svensson/papers/Buba%20709.pdf

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 3, by Clark Johnson)

Guest post: Part 3 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

(See the first and second post in this series)

Arguments for Fiscal Activism 

a)    New Money and Money Demand

Keynes’ premise is not credible.  Monetary economics routinely identifies channels other than interest rates through which additional money creation can affect demand.  For example, Frederic Mishkin, former member of the Fed Board of Governors, has identified channels of exchange rates, financial asset prices, real estate prices, wealth effects on consumption, and increase in bank lending capacity (among others) through which demand can be increased.[1]  Pertinent here, Keynes himself sometimes made the argument that monetary expansion could boost demand directly, independent of impact on interest rates.

For example, in the Treatise chapter on “Monetary Factors,” Keynes noted that monetary stimulus might bring together a previously “unsatisfied fringe of would-be entrepreneur borrowers who were ready to borrow … even at the old terms [i.e., without lowering interest rates], and … an unemployed fringe of the factors of production [workers] to offer employment to additional quantity of the factors of production.”  In an additional impact, he wrote that “certain entrepreneurs may now be willing to increase their output even if this means making higher offers than before to the factors of production because (as the ultimate result of the influx of new money) they forsee profits.”[2]  As Keynes here demonstrates, the underlying goal of monetary expansion is to satisfy an unmet demand for money.  The consequence may be to lower interest rates, but it may also work by directly increasing demand for goods and services, and for credit to purchase them.

The General Theory has comparable passages.  In Ch. 11, on the “Marginal Efficiency of Capital,” he linked changes in investment prospects to prior changes in prices.  He wrote, “the expectation of a fall in the value of money [i.e., inflation] stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand schedule.”  Consider that it is just this link between higher prices – as a result of the dollar depreciation — and the large increase in industrial production that Keynes minimized in his earlier-cited comments on the US recovery in 1933.  In Ch. 21, on the “Theory of Prices,” Keynes noted that “new money” could lead directly to increases in effective demand, which would be “divided between the rise of prices, the rise of wages, and the volume of output and employment.”[3]  Turning again to the illustrations in the Section 1, in three of them – the 1890s commodity deflation, the slump of 1930, and the near-depression of 1937-1938 — lack of “new money” was at the heart of the downturn.

The way Keynes understood monetary policy to work did not require him generally to reject monetary measures in order to boost aggregate demand.  Most likely, Keynes was instead motivated by a deeper structural view of the economic system in crisis, one driven by a transformative vision.  His views on monetary policy and his social philosophy came together in the forecast for a declining marginal efficiency of capital.

In Ch. 16 of the General Theory, Keynes anticipated a future “where capital goods would be so abundant” that the average marginal efficiency of capital would fall to zero.[4]  It was a logical extension of his view of financial markets, driven by fickle expectations, and of what in the early 1930s was growing “bear” sentiment.  He added in the final chapter, “Concluding Notes on the Social Philosophy Toward Which a General Theory Might Lead,” that such an abundance of capital would bring about the  “euthanasia of the rentier, of the functionless investor,” which he described as an “aim” of public policy, one perhaps to be realized “within one or two generations.”[5]   His notion was similar to the Marxian concept of a declining rate of profit — following accumulation of physical capital.  The stagnationist thesis, Keynesian or Marxian, resonated with the Left, especially during the depressionary Thirties.  It was a thesis about the real sector, about production and distribution, about capitalism and power.  Keynes’ proposed remedy was to scale back the reach of market relations, and to replace them with an expanded role for the State.  And there was no room in this vision for anything so apparently skin-deep as expansionary monetary policy to restore growth and boost the marginal efficiency of capital.  It is unusual to find a Marxian or Socialist economist who will consider monetary policy as other than a distraction.  Keynes’ own goals were more moderate – to overcome deficiency of demand and, thereby, to undermine the appeal of Communism and Fascism.[6]

Leaving the longer term horizon and returning to the causes of Depression in the early 1930s, Keynes wrote at the end of the General Theory:  “It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated – and in my opinion, inevitably associated – with present day capitalistic individualism.”[7] Had Keynes proposed monetary easing through open market operations, his inferred premise would have been that the capitalist system was structurally sound – merely that money demand was, for the moment, not being satisfied – hardly the stuff of a self-described revolution in economic thinking.

The case since the 1930s for a collapsing rate of profit following accumulation of capital has little evidence to support it.  Keynes underestimated potential demand for new investment, not to mention ongoing obsolescence of previous investment, in a world with seven billion people, most of them seeking to enhance their material comfort and social status.  A. C. Pigou, Keynes’ oft-times nemesis, dismissed the stagnationist thesis almost immediately, noting “An era that has witnessed the development of electrical apparatus, motor cars, aircraft, gramophone and wireless, to say nothing of tanks and other engines of war, is not one in which we can reasonably forecast a total disappearance of openings for new investment.”[8]

Keynes’ view that the world depression of the 1930s was caused by “capitalistic individualism” has done more damage.  As we have seen, the major downturns during the decade of depression were driven by gold standard rigidity, reserve shortages, inopportune central bank sterilization, and to a lesser extent by anti-market micro-economic policies associated with the New Deal.  Major economic boosts came from currency depreciations against gold and subsequent monetary ease.  The problem was not markets run amuck, irrational pessimism on stock exchanges, excessive capital accumulation, or lack of government stimulus.  Whatever the all-in contribution of the General Theory, it had the unfortunate consequence of diverting attention from the monetary dynamics that had brought depression.  Alas, Keynes’ legacy as received some three generations on has contributed to the confusion that fiscal stimulus is the best way to boost demand, while monetary policy is often perceived as either  ineffective or as just tinkering – when, some would have it — drastic structural change is necessary.


[1] Frederic S. Mishkin, The Channels of Monetary Transmission: Lessons for Monetary Policy, NBER Working Paper 5424, Feb. 1996.

[2] Treatise, Ch. 17 (i).

[3] General Theory, p. 298.

[4] General Theory, pp. 213f, 218.

[5] General Theory, p. 376.

[6] Robert Skidelsky, John Maynard Keynes 1883-1946: Economist, Philosopher, Statesman (2003), p. 538.

[7] General Theory, p. 381.

[8] Pigou quoted in Skidelsky, e.g., p. 539.

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 2, by Clark Johnson)

Guest post: Part 2 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

(See the previous post in this series here)

a)    The 1937-38 Contraction in the US

A few years later, Keynes disregarded evidence of the role of monetary policy in triggering a sharp relapse into near-depression conditions in the US during 1937-1938.  The dollar depreciation of 1933 and the formal increase of the gold price to $35/ ounce in 1934 meant automatic revaluation of central bank gold stocks and gave impetus to increased gold exploration and production – concentrated, as it happened, in the Soviet Union.  (Keynes noted the irony that increased Soviet efficiency in mining of gold was bailing out world capitalism!) He also noted that new gold reserves were bringing increased effective demand to the world economy that might result in “abnormal profits.” [1]  Keynes understood (at least some of the time) the role of growing liquidity in the economic recovery of the mid-1930s.

In what now appears as one of the worst mis-steps in its history, the Federal Reserve, responded to rising wholesale prices in 1936 by deliberately sterilizing new gold inflows.[2]  A money supply measure (M2) that increased by 12 percent annually during 1934 -1936, suddenly turned flat and even slightly negative from about January 1937 to July 1938.[3]  Real GDP fell by 11 percent during this period, and industrial production fell by 30 percent.  Rather than sterilize gold, had the Fed intervened in financial markets to target a modest rate of increase in any of a number of variables – a price index, industrial production, either real or nominal GDP growth, even a money supply indicator – most of the 1937-1938 contraction could have been avoided.  By August 1938, the sterilization policy was jettisoned, and economic recovery resumed.

In February 1938, Keynes offered advice in a private letter to President Roosevelt that mentioned little of this.  He did acknowledge that addressing “credit and insolvency problems” was an essential step toward recovery, as this created a necessary “supply of credit” – while, one infers, demand for that credit would have to come from elsewhere.  This comment reflected Keynes’ ongoing view that expected returns on investment – the schedule of marginal efficiencies of capital — was independent of monetary policy.  He went on the recommend that the US could “maintain prosperity at a reasonable level” only through “large-scale recourse to … public works and other Investments aided by Government funds or guarantees.” [4]

Despite Keynes’ recommendations, the lesson of all four of the illustrations here is that increasing money balances – through open market purchases, or through new gold or foreign exchange reserves – does affect expected returns on investment in plant and equipment, in equities, and in real estate.

ARGUMENTS FOR FISCAL  ACTIVISM

We could stop here, having assembled evidence of Keynes’ dubious conclusions about relative un-importance of monetary factors in specific pivotal events.  Indeed, evidence from these cases points strongly in the opposite direction, toward the crucial role of such factors.  But the prominence of Keynes’ fiscalist legacy requires that we go further.   Evidence aside, what was Keynes’ argument?   In fact, he had a sequence of arguments.

In 1929, Keynes offered a comparative argument in favor of fiscal stimulus, and against monetary stimulus, specific to economic circumstances in Britain at the time.[5]  Keynes anticipated some portion of an argument Robert Mundell was to make decades later regarding the “policy mix,” that is, the appropriate mix of monetary and fiscal policy to meet both domestic output and external exchange rate targets.[6]  Britain in 1929 was on the international gold standard, hence was constrained externally by the need to maintain gold reserves.  The Bank of England could not simply create credit, because, Keynes reasoned, “such credit might find its way to foreign borrowers, with the result of a drain of gold out of the Bank.”  Hence Keynes proposed fiscal stimulus to increase domestic demand and employment, alongside monetary constraint to maintain Britain’s reserve and exchange rate targets.

This well-grounded argument also offers possible insight into the 1890s, where demand for gold reserves among central banks generated monetary contraction.  Keynes, as we saw, did not make that argument – but we can construct it post facto.  While the best solution might have been some international agreement to increase demand by modifying the international gold standard, a purely national approach could have looked to a fiscalist demand boost.  But Keynes soon abandoned this policy-mix argument.

a)    Removing external constraint on Monetary Policy

The US had freedom of action in monetary policy in 1933 and 1934.  By March 1933, the dollar had been floated against gold, hence removing the external policy constraint – and, in any event, the US had by then accumulated vast gold reserves.  In Keynes’ comments in January 1934, he had moved beyond his 1929 analysis.  His newer interest was to argue that fiscal activism was preferable to monetary expansion even if the latter was not constrained.

Keynes in the General Theory (Ch. 15, “Incentives to Liquidity,”) offered the argument that monetary policy was specifically unsuited to boost economic demand when interest rates approached zero percent.  In conditions where interest rates could not be lowered further, he reasoned, a condition of “absolute liquidity preference” held, later dubbed a “liquidity trap.”  He observed, “In this event, the monetary authority would have lost effective control over the rate of interest.”  This argument is cited endlessly by later-day Keynesians in support of a fiscalist agenda.  (For example, see the reference to Summers mentioned at the outset.)

But the argument establishes much less than Keynes needed for his fiscalist agenda.  Near-zero interest rates did not prevail in any of the four situations discussed earlier – yet Keynes wanted fiscal activism in all of them.  So his case against monetary activism went beyond situations of absolute liquidity preference.

As noted earlier, Keynes pointed to a collapse in the marginal efficiency of capital as the trigger for the “slump of 1930.”  The General Theory does much more to advance the concept that investment volume is unstable.   Much of Keynes’ vision for government intervention, including fiscal activism, follows from his discussion of the fickleness of financial markets (Ch. 12, “Long Term Expectations.”)  Noting the instability of private sector investment volume, he advocated a larger role by the government in stabilizing investment demand, often through direct outlays.

Keynes’ argument often shifted from the instability of the investment function to concern that investment was and would remain chronically weak – hence the conclusion that high unemployment was not self-correcting, but could persist for years.  In Ch. 17 on the “Essential Properties of Interest and Money,” Keynes noted situations where the:

…rate of interest declines more slowly, as output increases, than the marginal efficiencies of capital-assets measured in terms [of the same asset].[7]

As formulated in one of several instances in Ch. 22 (“Notes on the Trade Cycle”):

A more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.[8]

This pattern of falling marginal efficiencies of capital made Keynes increasingly skeptical of monetary remedies.[9]

A counter-argument is that adding liquidity – through open market purchases, gold inflows, or variations on these – might directly boost demand, and hence boost the marginal efficiency of capital, by increasing cash balances.  But Keynes usually argued, to the contrary, that monetary policy worked mainly through raising or lowering interest rates –this was certainly a premise of the “liquidity trap” argument in Ch. 15.  Further on, he wrote that “the primary effect of a change in the quantity of money on the quantity of effective demand is through its effect on the rate of interest.”[10]  In the Treatise chapter on “Control of Investment,” where he calls for open market operations a outrance, the goal is to bring “the market rate of interest … down to the limiting point.”  In 1937 articles on “finance,” where Keynes stressed the crucial role of monetary policy, he again emphasized the channel of lowering interest rates.[11]


[1] Keynes, “The Supply of Gold,” Economic Journal, Sept 1936.

[2] That is, coupling purchases of gold with offsetting sales of other central bank assets to drain liquidity

[3] Doug Irwin, Gold Sterilization and the Recession of 1937-1938,  NBER Working Paper No. 17595, Nov 2011.

[4] In Collected Works of JM Keynes, Vol 21, pp. 434-39.

[5] Keynes, “A Program of Expansion (General Election, May 1929),” in Essays on Persuasion (1931), p. 124f.

[6] For ex., Robert Mundell, The Dollar and the Policy Mix (1973)

[7]Keynes, General Theory of Employment, Interest, and Money (1936), p. 236.

[8] General Theory, p. 315.

[9] Axel Leijonhufvud offers a variation on this argument with the comment that in in Ch. 37 of the Treatise “the assumption that entrepreneurs are right was dispensed with” – that is, entrepreneurs became, in Keynes’ judgment, excessively bearish.  In “Keynes and the Effectiveness of Monetary Policy,” Information and Coordination (1981).  Leijonhufvud argues that Keynes’ subsequent arguments therefore relied more on fiscal intervention.

[10] General Theory, p. 298.

[11] For ex.,Keynes, “The ‘Ex Ante’ Theory of the Rate of Interest,” Economic Journal 46 (1937)

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 1, by Clark Johnson)

I am extremely happy to announce that my blog this week will feature four guest posts by Clark Johnson. I have for some time tried to convince Clark to write something for my blog so I was very happy when Clark’s manuscript for his paper Keynes:  Evidence for Monetary Policy Ineffectiveness?” arrived in my in-box recently. Clark and I have decided to split up the paper in four parts which will be published in the coming four days.

Clark Johnson is not only a brilliant economic historian and author of the great book “Gold, France, and the Great Depression, 1919-1932″, but he is also a clever observer of the current monetary policy debate. Clark last year authored an insightful paper on the causes of the Great Recession, which in my view already is a Market Monetarist classic.

Lars Christensen

Guest post 

Keynes:  Evidence for Monetary Policy Ineffectiveness? (Part 1)

by Clark Johnson

Lawrence Summers, who was President Obama’s chief economist during 2009-2010, and who by accounts continues to be an important advisor, recently called on the US and other government to increase borrowing at current very low interest rates.[1]  He observes that, based on inflation-protected bond rates, current Treasury borrowing costs for securities of five and ten year maturities are negative.  He adds that interest rates elsewhere in the world – Germany, Japan, and Britain – are also extremely low.  He then argues that governments should look on such rates as an opportunity to borrow cheaply and thereby improve their long-term fiscal positions.

Summers is presumably correct from a fiscal management perspective about benefits of borrowing when interest rates are low.  But as a macroeconomic strategy for recovery, that is only the beginning.  Whether we turn to John Taylor on the right or Paul Krugman on the left, the essential element for fiscal stimulus to succeed is to stabilize expectations: will the stimulus continue for long enough to drive expectations, so that market participants know the boost will ongoing and not soon withdrawn?    Summers’ then shifts to monetary policy, where his case is weaker.  He says there is no point in “quantitative easing”, the open-market mechanism the Federal Reserve uses to inject reserves, as interest rates are already rock-bottom – and monetary easing works, he explains, through the mechanism of lowering interest rates.  Presumably, this is what he has been telling Obama since 2009.

Summers’ reasoning draws at least in part, on John Maynard Keynes’ discussion about “absolute liquidity preference” that occur when interest rates are very low, and demonstrates a key argument used in policy circles against more aggressive use of monetary policy.   I believe Keynes was, and Summers is, mistaken.  Literature on Keynes is abundant.  To gain a different perspective, I want to look at various evidence Keynes adduced against monetary remedies.  I will then return to arguments he used in the General Theory (1936) and elsewhere, hopefully with fresh perspectives.

KEYNES’  ILLUSTRATIONS FOR MONETARY POLICY INEFFECTIVENESS

A portion of Keynes’ reputation as an economist, and of his place in history, rest on his diagnoses of crisis situations and his proposed remedies.  Well-known examples include his tract on the post-World War One Versailles Conference, The Economic Consequences of the Peace (1921), and subsequent writings on hyperinflations and then on British deflation during the 1920s.   Another, less well-known, was his discussion of French monetary and political crises during 1925 and 1926, which I credited in my own work on the period.[2]  His two-volume Treatise on Money (1930) provided detailed and often shrewd observations on a wide range of economic policy matters.

In contrast, the General Theory, the heart of Keynes’ contribution to economic ideas, is light on historical or even contemporary illustration.  So the reader seeks to fill in the gaps by turning to other writings.  Consider four prominent cases as they reflect on Keynes’ view of roles of monetary and fiscal policy.

a)    British Deflation in the 1890s

An unexpected embrace of fiscal activism comes in the Treatise discussion of the deflation of the early 1890s, where Keynes argued that the Bank of England’s gold reserves were abundant and credit was easy.  But prices in Britain and the world nevertheless went into decline, which undermined profit and investment and reduced employment.  He wrote:

I consider, therefore, that the history of this period [1890-1896] is a perfect example of a prolonged Commodity Deflation – developing and persisting in spite of a great increase in the total volume of Bank-Money.  There has been no other case where one can trace so clearly the effects of a prolonged withdrawal of entrepreneurs from undertaking the production of new fixed capital on a scale commensurate with current savings.

Keynes then concluded (anticipating his arguments a few years later, including in the General Theory,) that monetary expansion does not always work, and that there might therefore be a role for public investment projects to boost demand.[3]

Keynes’ discussion of the 1890s misses the point.  Britain in the late nineteenth century was part of an open world economy, with easy movement of goods, people, and especially capital.  Keynes neglected to mention that system-wide demand for gold rose much more than the supply from the 1870s through the 1890s as nearly two dozen countries adopted or re-adopted the gold standard, and hence needed to accumulate reserves.  Indeed, demand drove the commodity-exchange value of gold to the highest level it was to reach in four centuries of record-keeping[4] — the flip-side of commodity price deflation.  The commodity price decline reduced profits and chilled investment demand; but commodity prices were determined in international markets, not in Britain.

While demand for gold was surging, the world’s monetary gold supply in the mid-1890s was at its lowest point it was ever to reach relative to its 1800-1920 trend line.[5]  As the mines in the South African Rand cranked up production in the 1890s, relative gold supply and commodity prices increased, nearly in tandem after 1896 – thus ending the Commodity Deflation, and initiating a gentle inflation.  A growing money stock affected not just the supply of credit (as reflected in a declining interest rate), but also the demand for it.  A result was nearly two decades of economic growth in all of the industrial powers, which was sadly interrupted by the First World War.

Monetary events were at the heart of both the origins of and recovery from the depression of the early 1890s.  Keynes himself gave this backhand acknowledgement with his comment a few paragraphs later that, “the fall of prices [in the early 1890s] could only have been avoided by a much greater expansion of the volume of bank-money.”  It is revealing that Keynes could discuss price trends during that period without mentioning the geographic expansion of the gold standard – easily the most important monetary development of the era.

b)    The onset of the Great Depression

Moving to then contemporary events, Keynes’ discussion of the “slump of 1930,” also in the Treatise, builds on similar themes.[6]  Gustav Cassel and Ralph Hawtrey had argued a few years earlier that the undervaluation of gold following restoration of gold standards at prewar gold prices would force world-wide monetary contraction, especially as former belligerents Britain, France, Germany, and Italy restored their gold standards.   Keynes, in contrast, told the Royal Commission on Indian Currency in 1926 that central banks would adjust their currency reserve cover ratios if  their gold stocks became inadequate – which allowed him to dismiss the danger.  Keynes underestimated what we might call the mystique of gold money.

Keynes listed factors driving interest rates higher during the 1920s: corporate borrowing for new industries; governments borrowing to pay reparations and war debts; central banks borrowing to add reserves; and speculators borrowing to buy shares of stock.  He identified but was less able to explain the collapse internationally in anticipated returns in investment – what he would later call the marginal efficiency of capital — that occurred in the mid-1920s.  As in considering the early 1890s, he did not connect the fall-off in real yields on new investment with systemic monetary constraint.  Parallel to what happened in the 1890s, the middle and late 1920s saw a commodity deflation as key countries adopted or returned to gold standards.  He thought monetary expansion worked through lowering interest rates, without directly affecting demand for goods and services.  He wrote that the only ways to boost demand were by lowering interest rates, especially long rates, further – or by government fiscal activism.  He did not understand that the world required a higher gold price to restore gold-to-currency reserve ratios, or perhaps needed a departure from gold money altogether.

c)     The Roosevelt Recovery in 1933

Keynes’ comments in January 1934 on the monetary-fiscal mix in the US were baffling.  In one of his initial acts after Roosevelt’s accession to power in March 1933, the dollar was allowed to depreciate against gold.  This was a momentous event in monetary history – the underlying cause of the interwar deflation had been removed, and the gold standard was never restored with the same conviction.  Keynes nevertheless wrote:

One half of [Roosevelt’s] programme has consisted in abandoning the gold standard, which was probably wise, and in taking various measures … to depreciate the gold value of the dollar… [But i]t is not easy to bring about business expansion merely by monetary manipulation.  The other half of his programme, however, is infinitely more important and offers in my opinion much greater hopes.  I mean the effort to cure unemployment by large-scale expenditure on public works and similar purposes.[7]

This summary scarcely acknowledges the results of the real-time experiment in expansionary monetary policy undertaken in the US within the previous year.  Depreciation succeeded at least to the extent any advocate could have hoped.  Industrial production soared by 57 percent during the first four months of the Roosevelt Administration beginning in March 1933 – this was the actual increase, not an annualized rate — making up half of what had been lost since 1929.  It was the fastest four-month rate of expansion in industrial production in the history of the US. Yet Keynes apparently considered this event to be “infinitely” less important than the boost to come from fiscal borrowing for public works programs.

Had the experiment continued for a few months more, pre-crash production levels might have been recovered.  Unfortunately, the NIRA (National Industrial Recovery Act, announced in July 1933, brought micro-policy changes that had the effect of stopping the recovery in its tracks.  The NRA (National Recovery Administration), set up under NIRA, then negotiated specific sets of codes with leaders of the nation’s major industries; the most important provisions were anti-deflationary floors below which no company would lower prices or wages, and agreements on maintaining employment and production. Within a short time, the NRA reached agreements with most major industries. In a phrase, the NIRA wanted to increase prices by restricting output rather than by increasing demand.   Scott Sumner provides several rounds of evidence for the contractionary impact of NIRA policy in his soon-to-arrive book, The Midas Curse: Gold, Wages, and the Great Depression.

Lest this appear suspect as a predictable right-wing narrative of the New Deal, consider that Keynes himself pointed to the “fallacy” of the NRA approach: He noted that “rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.”  He added that it was “hard to detect any material aid to recovery in the National Industrial Recovery Act.”[8]  Within six months after the NRA went into effect, industrial production had dropped twenty-five percent,[9] erasing nearly half of the gains recorded during Roosevelt’s more successful initial months in office.

So here we are.  We saw an historically sharp recovery for four months during 1933, driven almost entirely by a decision to break the straightjacket imposed on monetary policy by the international gold standard.  Keynes had previously been an able critic of the gold standard, for example in the Tract on Monetary Reform (1923) and then in several chapters in the Treatise. The 1933 recovery was then stalled by micro-policies of which he was explicitly critical.  Yet Keynes seemed to dismiss this entire episode in his call a few months later for fiscal stimulus!


[1] Lawrence Summers, “Look beyond interest rates to get out of the gloom,” Financial Times, 3 June 2012

[2] H. Clark Johnson, Gold, France, and the Great Depression, 1919-1932  (Yale, 1997)

[3] John Maynard Keynes, Treatise on Money (1930), Ch. 30 (ii).

[4] Roy Jastram, The Golden Constant (1977)

[5] League of Nations chart, reproduced in Johnson, p. 52.

[6] Treatise, Ch. 37 (iv) “The Slump of 1930.”

[7] Keynes, “Roosevelt’s Economic Experiments,” The Listener, 17 January, 1934.

[8] Keynes, “Mr. Roosevelt’s Experiments,” London Times, 02 Jan 1934.

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